Volatility is back! Perhaps that is the understatement of 2018 as we have watched global equity markets enter into- and rebound out of – correction territory in February. Just two weeks ago the market theme was FOMO – fear of missing out – and traders/investors couldn’t snap up shares of their favorite equities fast enough. Fast forward just 5 trading days and we are in the “no wanter market” – sellers overwhelming buyers in an “elevator down” fashion. As you might imagine, the prognosticators are back in force with their predictions – some calling for further “doom and gloom” as the markets reset to the idea of higher interest rates and tighter money supply while others call for a complete rebound and new highs ahead. Who will be right and who will be wrong? Only time will tell. What is most important is how we as investors/traders handle any market situation – present or future – through effective risk management skills and plans.
All trading and investing decisions begin with an expectation of future equity price behavior. We know that equities don’t go up – or down – in straight lines forever. The most recent leg of the bull market took the S&P to all-time highs just a few weeks ago on the expectation that the underlying economic conditions are solid and will continue to improve for the foreseeable future. Even though interest rates are rising, they are doing so at a very slow pace. Earnings and revenues for S&P 500 companies are growing and with the recent selloff, the overall P/E multiple on the market was lowered. It looks like it could be an interesting time to “buy the dip” – as long as it doesn’t turn into a falling knife! One way to get involved in the market but have some degree of hedge against downward pressure is by creating a covered call.
Owning shares of an individual equity or ETF works only in a bullish trend. Since equities spend a fair amount of time either consolidating recent moves (stagnant trend) or in pullback mode (bearish trend), it stands to reason that we can improve overall trading performance by opening up multiple trends for success in our trades. One way to do this is to create a covered call. By selling a call option against your shares, you can make money when your shares go up, stay sideways or even drop slightly. Here’s an example on the SPY, the ETF that serves as a proxy for the S&P 500:
Buy 100 shares of the SPY at $266.38
Sell a March 2018 269 short call – take in a credit of $ 4.46/share
Cost basis in this trade = $261.92/share
Maximum reward in the trade = $269.00-261.92 = 7.08/share – 2.7% return in 32 days
The short call gives you to obligation to sell your shares upon March option expiration (March 16, 2018) if the SPY is trading above $269/share. Therefore, a very bullish or somewhat bullish trend will give you your maximum reward. If the SPY remains under $269, you will keep the credit you received for selling your short call providing you profit while maintaining share ownership. If you just owned shares and the SPY was stagnant, you would only be at breakeven. By selling this call, you added a piece to the trade that gives you profit in the stagnant trend. If the SPY were to pull back slightly, you can maintain some degree of profitability as long as it remains above your cost basis of $261.92. This in effect gives you a small hedge against bearish price action.
I believe 2018 has been and will continue to be a more challenging year for investors than was 2017. Having the peace of mind that successful hedging provides enables me to continue to be profitable in my trading while sleeping well at night. What a winning combination!